That’s at least one of the messages to be gleaned from this week’s revelation in the Financial Times that the Fed is considering the imposition of exit fees on bond funds. The purpose of these fees, in the Fed’s reasoning, is to discourage investors from exacerbating a downturn by selling their funds into a weak market.

At its core, this is an issue of very liquid investments (i.e., bond funds) that in many cases hold illiquid securities which the managers might not be able to sell at a reasonable price if they’re forced to meet heavy redemptions. This leads to a vicious cycle in which lower prices fuel additional selling, which pushes prices lower, and so on.

This is absolutely a valid concern, as evidenced by the downturn in the high-yield market during the 2008 crisis.

But exit fees are a poor solution, and it’s concerning that the Fed would even discuss such a possibility.

Aside from the optics — in this case, a move toward the type of capital controls usually reserved for governments in the Third World — the plan is foolish for two simple reasons:

You’re Going to Get a Run on Bond Funds Anyway

First, by giving investors a specific date at which they will no longer be able to redeem their funds without paying an extra fee, the Fed would almost guarantee a run on bond funds. After all, anyone who was thinking of selling their fund at any point in the next few years would inevitably speed up their exit to avoid the fee. This would create the exact selling pressure the Fed is looking to avoid in the first place.

In fact, it would probably make matters even worse by undermining confidence in the marketplace.

In other words, the very action designed to stop something that might happen (selling as a result of rising rates) would ensure that it did happen.

It’s also highly unlikely that the stock market would be able to make it through a selloff in corporate and high-yield bonds without sustaining significant damage of its own.

Who Exactly Collects These Exit Fees?

The second issue is the question of who receives the redemption fee.

Is it the fund companies themselves? If so, the Fed is promoting the redistribution of wealth from individuals to large financial institutions. Not only does this needlessly penalize fund investors, but it’s a nonstarter in the current political environment.

The Fed’s tone-deafness with regard to this issue is particularly egregious given the reason why investors have put so much money in bond funds and ETFs in the first place: Fed policy. The low rates on traditional low-risk options such as bank products, savings bonds, short-term Treasuries, etc., have been a key factor forcing investors out of the risk curve into bond funds.

In this sense, the Fed has encouraged investors to take risk, but slapping exit fees on bond funds would then penalize them for doing so.

More than anything, it’s this aspect of the exit fee that makes the idea so appalling.

Bottom Line

It’s highly improbable that this rule will ever go into effect, and it’s likely that the FT article simply represented a trial balloon.

Still, the fact that the Fed would even discuss bond fund exit fees carries a lesson for investors. The central bank sees systemic risk not just from the role of bond funds and ETFs in the marketplace, but also the potential that rising rates could fuel an exodus from these funds at some point in the future.

Investors should consider this a sign that even with the strong returns of this year’s first half, an era of subpar bond market returns is a virtual certainty in the years ahead.